Several studies have suggested the benefits of measuring ESG performance to pay; however, reservations still exist
Environmental, Social, and Governance (ESG) are metrics used to describe the performance and sustainability of a company beyond traditional financial yardsticks like “return on investment” . There are no set rules or one-size-fits-all metrics for measuring ESG performance. Companies may consider measures such as, customer service, employee and customer satisfaction, environmental impact, employee safety record, community impact, diversity, equity, and inclusion (DEI), affirmative action, and pay equity.
Many companies have started to adopt ESG measures as part of compensation because they recognize that ESG is a priority in today’s environment, and they feel like they are responding to investor and other stakeholder expectations. There have been three recent studies that address linking executive compensation to ESG performance. The results are fascinating and varied.
1. Linking Executive Compensation to ESG Performance, prepared by The Conference Board, along with Semler Brossy and ESGAUGE, was based on roundtable discussions held at the end of the 2022 proxy season. It concluded that the majority (73% in 2021) of companies in the S&P 500 are incentivizing and rewarding management behaviors by “tying executive compensation to some form of ESG performance.”
- The report identifies the following four different approaches to tying pay to ESG metrics:
“Stand-alone ESG metric: ESG is incorporated through specific (often quantitative) metrics.
- Business strategy scorecard: ESG goals are included and assessed as part of a broader scorecard of ESG or nonfinancial business priorities.
- Individual performance assessment: ESG is considered as part of an executive’s individual performance rating, which is often a discretionary assessment by the company’s compensation committee.
- Modifier: ESG can be used to adjust the financial performance rating, the overall rating, or the payout under a plan.”
According to the report, 49% of ESG goals are included in individual performance assessments and 48% in business strategy scorecards; however, some companies combine these approaches. Companies are linking compensation to ESG measures for non-executives, “reflecting that achieving ESG goals requires the collective effort of the employees.” As explained in the report, some large investors have been “agnostic about ESG-based pay due to the lack of standardization and transparency,” especially when companies do not create a business case for doing so.
The Conference Board report suggests that companies should assess their current progress on ESG and engage with their investors to ascertain their views on ESG metrics as part of executive compensation.
2. Institutional Shareholder Services Inc. (ISS), 2021 Global Benchmark Policy Survey and Climate Survey, indicates that 52% of investors believe that ESG goals should be part of executive pay only “if they are specific and measurable.” The ISS study included 409 responses and covered numerous topics including the use of non-financial ESG performance metrics in executive compensation and racial equity audits.
3. Harvard Law School Program on Corporate Governance, The Perils and Questionable Promise of ESG-Based Compensation, March 2022, exposes the fundamental flaws and limitations of using ESG performance metrics for executive compensation. The results are based on empirical analysis of the use of compensation-based metrics in S&P 100 companies. The authors feel that “by incentivizing executives to improve performance on narrow and very partial measures, the current practice disincentivizes corporate leaders from focusing on many other important aspects of stakeholder welfare and fails to improve overall incentives,” and may well “ultimately hurt, not serve, aggregate stakeholder welfare.”
This study found that company disclosures regarding performance goals were too vague and non-specific and failed to disclose the outcomes for an outsider to determine “meaningfulness of the performance." The authors “warn that the use of ESG metrics threatens to reverse the progress achieved in the past few decades in making executive pay more transparent, more sensitive to actual performance, and more open to outside oversight and scrutiny.” They concluded that “current practices regarding the use of ESG metrics, and the trend to increase their use, represent a serious setback in the attempt to address and mitigate the agency problems of executive compensation.”
Whether or not a company incorporates ESG measures into incentive pay plans demands a rigorous and customized approach of self-assessment, instead of just doing it because it is trendy. A critical first step is to make sure that the company has an established ESG plan in place with a clear understanding of where they stand on each element. Only then should they determine if they have a business case for adopting the incentive plan, followed by an analysis of the costs and benefits of adopting ESG performance goals. The Conference Board study advises that ESG goals should be: (1) “clearly defined, (2) aligned with its business strategy, and (3) reflective of its key ESG risks and opportunities.”
Companies should assess their current progress on ESG and engage with their investors and other stakeholders to ascertain their views on ESG metrics as part of executive compensation.
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